What Is a Residual Dividend?
A residual dividend is a dividend policy that companies use when calculating the dividends to be paid to shareholders. Companies that use a residual dividend policy fund capital expenditures with available earnings before paying dividends to shareholders. This means the dollar amount of dividends paid to investors each year will vary.
- Residual dividend policies are adopted by companies to prioritize capital expenditures over immediate shareholder dividend payments.
- Companies that maintain a residual dividend policy invest in growth opportunities from profits before paying shareholders their dividend.
- Management adopts a residual dividend policy to invest in the company’s development, such as upgrading manufacturing capacity or adopting new methods to reduce waste, theoretically resulting in greater long term growth.
- With an immediate reduction in dividend payouts and fluctuation on the amounts over time, management may need to justify its decisions to shareholders.
- The residual dividend policy is adopted based on the belief that investors do not have a preference whether their returns are in the form of immediate dividends or long-term capital gains.
How a Residual Dividend Works
A residual dividend policy means companies use earnings to pay for capital expenditures first, with dividends paid with any remaining earnings generated. A company’s capital structure typically includes both long-term debt and equity, where capital expenditures can be financed with a loan (debt) or by issuing more stock (equity).
The residual dividend policy’s success can be calculated by dividing net income by total assets to calculate the return on assets, which is a metric that helps analyze the management’s decision.
While shareholders may accept management’s strategy of using earnings to pay for capital expenditures, the investment community analyzes how well the firm uses asset spending to generate more income. The return on asset (ROA) formula is net income divided by total assets, and ROA is a common tool used to assess management’s performance.
If the clothing manufacturer's decision to spend $100,000 on capital expenditure is the right one, the company can increase production or operate machinery at a lower cost, and both of these factors can increase profits. As net income increases, the ROA ratio improves, and shareholders may be more willing to accept the residual dividend policy in the future. However, if the firm generates lower earnings and continues to fund capital expenditures at the same rate, shareholder dividends decline.
Requirements for Residual Dividend
When a business generates earnings, the firm can either retain the earnings for use in the company or pay the earnings as a dividend to stockholders. Retained earnings are used to fund current business operations or to buy assets. Every company needs assets to operate, and those assets may need to be upgraded over time and eventually replaced. Business managers must consider the assets required to operate the business and the need to reward shareholders by paying dividends.
For the residual dividend policy to work, it assumes the dividend irrelevance theory is true. The theory suggests that investors are indifferent to which form of return they receive from a company—whether it be dividends or capital gains. Under this theory, the residual dividend policy does not affect the company’s market value since investors value dividends and capital gains equally.
The calculation for residual dividends is done passively. Companies using retained earnings to finance capital expenditures tend to use the residual policy. The dividends for investors are generally inconsistent and unpredictable.
Example of Residual Dividends
As an example, a clothing manufacturer maintains a list of capital expenditures that are required in future years. In the current month, the firm needs $100,000 to upgrade machinery and buy a new piece of equipment. The firm generates $140,000 in earnings for the month and spends $100,000 on capital expenditures. The remaining income of $40,000 is paid as a residual dividend to shareholders, which is $20,000 less than was paid in each of the last three months. Shareholders might be disappointed when management chooses to lower the dividend payment, and senior management must explain the rationale behind the capital spending to justify the lower payment.